In a recent article in McKinsey Quarterly called “Working Out of Debt,” the venerable consulting firm tracks past deleveraging processes and compares them to the current process in the US, UK and Spain.

In a nutshell for the US, households appear to be about a year and a half away from reducing debt as a percentage of disposable income, to a rising trend line that would be at about 100% at mid-2013.  If, for example, the US was to follow a similar deleveraging path as Sweden, we can expect such deleveraging to continue to go below that trend line and bottom out in about four years.

Interestingly, due to declining debt levels and lower interest rates, the US household debt service ratio has declined from its peak of 14% in the third quarter of 2007 to 11.5%, lower than it was in 2000.

Household debt outstanding has fallen by 4 percent from the end of 2008 (near the Lehman blow-up) to the second quarter of 2011, says the article.  However, defaults have contributed 70-80% of the decline in mortgage and consumer credit.  Of the mortgage defaults, it is estimated that up to 35% were due to ‘jingle mail’, as homeowners walked away from their ‘underwater’ homes and mailed the keys to the lenders.

Of course, just because household deleveraging may come to a halt in a few years, it does not mean that re-leveraging will kick into high gear.  One wonders where any strong uptick in the borrowing power of consumers may come from, given the steep drop in home values and the relative lack of home equity borrowing availability.

We named this period of our economy as the “Greatest Deleveraging in the History of the World,” and discussed it at our Insurer Investment Forum in March, 2008.  But, little did we know that it would be as virulent or spread to other countries, as it is in the process of doing in Europe.

And, we did not expect the unprecedented borrowing spree from the federal government, which amounted to the “Greatest Re-Leveraging”.  However, if history of similar deleveraging incidents at other countries is a guide, we can expect the federal government to begin to show much lesser budget deficits as consumer deleveraging subsides and the economy begins a slow improvement.  After all, consumers drive over two-thirds of US GDP.

As noted in several earlier blogs and confirmed by this latest research from McKinsey, this Deleveraging will take time (and now may even be impacted by a severe Deleveraging in Europe).  But, at least it does appear we can see some light at the end of the tunnel.

Finally, over four years after the start of the Great Recession, the Fed, in a letter to Congress has started pushing some aggressive solutions to the housing crisis that may not sit well with investors and banks.

Read the letter here: http://www.federalreserve.gov/publications/other-reports/files/housing-white-paper-20120104.pdf

Bill Dudley, NY Fed President, Chairman of the Federal Open Market Committee, successor to Treasury Secretary Geithner…and Goldman Sachs alumus, of course…outlined a list of possible changes to housing finance mentioned in that letter.  Here are a few:

- refinancing made broadly available on streamlined terms and with moderate fees to all prime conforming borrowers who are current on their payments

(Looks like the FED is starting to realize that buying mortgages and maintaining the stifling ZIRP policy at least through the middle of next year is not good enough.  If you can buy an ice cream cone for only 10 cents, but don’t have a dime, the low price of the delicious desert serves as an unrequited temptation.  The same is true with low refi rates when it is nigh impossible to qualify for the refi, for a host of possible reasons.)

- an “earned” principal reduction for borrowers who are underwater but kept on making their mortgage payments

(More bad news for investors and banks, but it does have a bit of a moral tinge to it:  “If you’ve decided against ‘strategic default’, we will lower what you owe us.”  Although this may improve the probability of repayment and ultimately reduce downward pressure on housing prices, it is against the Santelli inspired rant that resonates with so many and is given some credit for igniting the Tea Party.  (http://youtu.be/zp-Jw-5Kx8k))

- Dudley also called for getting banks to accept more risk, have looser underwriting and smaller risk-based premiums, and getting appraisers to have less of a “downward” bias – just the opposite of urgings from bank regulators today.

- And he pushed for a $15 billion-a-year bridge loan program to those who are laid off so that they can keep paying their mortgage while finding a new job.

“Negative price expectations and flawed financing and administrative mechanisms, if left unaddressed, can contribute to ongoing weakness in housing demand and make it harder to generate a robust economic recovery,” Dudley said.  He also downplayed moral hazard concerns from offering homeowners relief and further said they would be in the interest of taxpayers.

The FED letter also emphasizes the importance of turning REO (real estate owned) or near REO homes into rentals, in order to stabilize the housing market.  In fact, a variant of this was proposed in our ‘From the Northwest Quadrant’ blog of November, 2008  (http://www.saai.com/index.php/lets-say-you-run-a-banka-modest-proposal/

…and was actually successfully accomplished by the FDR administration during the Great Depression.

The fact that these ideas are being mentioned by the FED at this late stage in the game…and publicized by a Goldman alum…shows just how serious the FED regards the housing crisis.   Alas, it also reminds me of John McEnroe’s retort to a tennis judge as shown in this video:  “You can’t be serious.” (http://youtu.be/ekQ_Ja02gTY)

Perhaps this time the FED just might be serious?  And if it is, one must think carefully about the potential impacts of government policy on your company’s investment in both non-agency and agency RMBS.

Chairman Bernanke once saw no problem in the subprime crisis.  But, perhaps the FED is now finally ready to actively and seriously discuss and promulgate viable alternative solutions to the housing crisis…instead of following a passive aggressive policy of keeping rates low, while leveraging its own balance sheet and hoping for the best.